Time Value of

Money
 The Interest Rate

Which would you prefer – Rs10,000

today or Rs10,000 in 5 years?

Obviously, Rs10,000 today.

You already recognize that there is

TIME VALUE TO MONEY!!
 Why TIME?

Why is TIME such an important

element in your decision?
TIME allows you the opportunity to
postpone consumption and earn
INTEREST

A rupee today represents a greater real

purchasing power than a rupee a year
hence
 Types of Interest

 Simple Interest
Interest paid (earned) on only the original
amount, or principal borrowed (lent).
 Compound Interest
Interest paid (earned) on any previous
interest earned, as well as on the
principal borrowed (lent).
 Simple Interest Formula

Formula SI = P0(i)(n)
SI: Simple Interest
P0: Deposit today (t=0)
i: Interest Rate per Period
n: Number of Time Periods
 Simple Interest Example
 Assume that you deposit Rs1,000 in an
account earning 7% simple interest for
2 years. What is the accumulated
interest at the end of the 2nd year?

SI = P0(i)(n)
= Rs1,000(.07)(2)
= Rs140
 Simple Interest (FV)
 What is the Future Value (FV) of the
deposit?
FV = P0 + SI
= Rs1,000 + Rs140
= Rs 1,140
 FutureValue is the value at some future
time of a present amount of money, or a
series of payments, evaluated at a given
interest rate.
 Simple Interest (PV)
 What is the Present Value (PV) of the
previous problem?
The Present Value is simply the
Rs 1,000 you originally deposited.
That is the value today!
 PresentValue is the current value of a
future amount of money, or a series of
payments, evaluated at a given interest
rate.
 Future Value
Single Deposit (Graphic)
Assume that you deposit Rs 1,000
at a compound interest rate of 7%
for 2 years.
0 1 2
7%
Rs 1,000
FV2
 Future Value
Single Deposit (Formula)
FV1 = P0 (1+i)1 = Rs 1,000 (1.07)
= Rs 1,070
FV2 = FV1 (1+i)1
= P0 (1+i)(1+i) = Rs1,000(1.07)(1.07)
= P0 (1+i)2 = Rs1,000(1.07)2
= Rs1,144.90
You earned an EXTRA Rs 4.90 in Year 2 with
compound over simple interest.
 General Future
Value Formula
FV1 = P0(1+i)1
FV2 = P0(1+i)2
etc.

General Future Value Formula:

FVn = P0 (1+i)n
or FVn = P0 (FVIFi,n)
 Problem
Reena wants to know how large her deposit of
Rs 10,000 today will become at a compound
annual interest rate of 10% for 5 years.

0 1 2 3 4 5
10%
Rs10,000
FV5
 Solution
 Calculation based on general formula:
FVn = P0 (1+i)n
FV5 = Rs10,000 (1+ 0.10)5
= Rs 16,105.10
 Double Your Money!!!

Quick! How long does it take to double

Rs 5,000 at a compound rate of 12%
per year (approx.)?

We will use the “Rule-of-72”.

  Doubling Period = 72 / Interest Rate

6 years

For accuracy use the “Rule-of-69”.

Doubling Period
=0.35 +(69 / Interest Rate)

6.1 years
 Present Value
Single Deposit (Graphic)
Assume that you need Rs 1,000 in 2 years.
Let’s examine the process to determine
how much you need to deposit today at a
discount rate of 7% compounded annually.
0 1 2
7%
Rs 1,000
PV0 PV1
 Present Value
Single Deposit (Formula)

PV0 = FV2 / (1+i)2 = Rs 1,000 / (1.07)2

= FV2 / (1+i)2 = Rs 873.44

0 1 2
7%
Rs 1,000
PV0
 General Present
Value Formula
PV0 = FV1 / (1+i)1
PV0 = FV2 / (1+i)2
etc.

General Present Value Formula:

PV0 = FVn / (1+i)n
or PV0 = FVn (PVIFi,n)
 Problem
Reena wants to know how much should
she deposit so that the money will grow to
Rs 10,000 in 5 years at a discount rate of
10%.
0 1 2 3 4 5
10%
Rs 10,000
PV0
 Problem Solution
 Calculation based on general formula:
PV0 = FVn / (1+i)n
PV0 = Rs 10,000 / (1+ 0.10)5
= Rs 6,209.21
 Types of Annuities
 AnAnnuity represents a series of equal
payments (or receipts) occurring over a
specified number of equidistant periods.
 Ordinary Annuity: Payments or receipts
occur at the end of each period.
 AnnuityDue: Payments or receipts
occur at the beginning of each period.
 Examples of Annuities

 Student Loan Payments

 Car Loan Payments
 Insurance Premiums
 Mortgage Payments
 Retirement Savings
 Parts of an Annuity

(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3

0 1 2 3

Rs 100 Rs 100 Rs 100

Today Equal Cash Flows

Each 1 Period Apart
 Parts of an Annuity

(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3

0 1 2 3

Rs 100 Rs 100 Rs 100

Today Equal Cash Flows

Each 1 Period Apart
 Ordinary Annuity -- FVA
Cash flows occur at the end of the period
0 1 2 n n+1
i% . . .
R R R
R = Periodic
Cash Flow

FVAn
FVAn = R(1+i)n-1 + R(1+i)n-2 +
... + R(1+i)1 + R(1+i)0
 Example of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period
0 1 2 3 4
7%

Rs1,000 Rs1,000 Rs1,000

Rs1,070
Rs1,145
FVA3 = 1,000(1.07)2 +
1,000(1.07)1 + 1,000(1.07)0 Rs3,215 =
FVA3
= 1,145 + 1,070 + 1,000
= Rs 3,215
General Formula for Calculating
Future Value of an Ordinary
Annuity
n 1 n2
FVAn  A(1  i )  A(1  i ) ... A

 (1  i )  1
n
 A 
 i 
 Annuity Due -- FVAD
Cash flows occur at the beginning of the period
0 1 2 3 n-1 n
i% . . .
R R R R R

FVADn = R(1+i)n + R(1+i)n-1 + FVADn

... + R(1+i)2 + R(1+i)1
= FVAn (1+i)
 Example of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period
0 1 2 3 4
7%
1,000 1,000 1,000 1,070

Rs1,145
Rs1,225

FVAD3 = 1,000(1.07)3 + Rs 3,440 =

1,000(1.07)2 + 1,000(1.07)1
FVAD3
= 1,225 + 1,145 + 1,070
= Rs 3,440
 Ordinary Annuity -- PVA
Cash flows occur at the end of the period
0 1 2 n n+1
i% . . .
R R R

R = Periodic
Cash Flow
PVAn
PVAn = R/(1+i)1 + R/(1+i)2
+ ... + R/(1+i)n
 Example of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period
0 1 2 3 4
7%

Rs1,000 Rs1,000 Rs1,000

934.58
873.44
816.30
Rs 2,624.32 = PVA3 PVA3 = 1,000/(1.07)1 +
1,000/(1.07)2 +
1,000/(1.07)3
= 934.58 + 873.44 + 816.30
= 2,624.32
 General Formula for Calculating
Present Value of an Ordinary
Annuity
A A A
PVAn    ... 
(1  i ) (1  i ) 2
(1  i ) n

 (1  i ) n  1
 A n 
 i (1  i ) 
 Annuity Due -- PVAD
Cash flows occur at the beginning of the period
0 1 2 n-1 n
i% . . .
R R R R

R: Periodic
PVADn Cash Flow

PVADn = R/(1+i)0 + R/(1+i)1 + ... + R/(1+i)n-1

= PVAn (1+i)
 Example of an
Annuity Due -- PVAD
Cash flows occur at the beginning of the period
0 1 2 3 4
7%

1,000.00 1,000 1,000

934.58
873.44

2,808.02 = PVADn

PVADn = 1,000/(1.07)0 + 1,000/(1.07)1 +

1,000/(1.07)2 = Rs 2,808.02
 Mixed Flows Example
Reena will receive the set of cash
flows below. What is the Present
Value at a discount rate of 10%?
0 1 2 3 4 5
10%
600 600 400 400 100
PV0
 Solution

0 1 2 3 4 5
10%
600 600 400 400 100
545.45
495.87
300.53
273.21
62.09
Rs 1677.15 = PV0 of the Mixed Flow
Shorter Discounting Periods
General Formula:
FVn = PV0(1 + [i/m])mn

n: Number of Years
m: Compounding Periods per Year
i: Annual Interest Rate
FVn,m: FV at the end of Year n
PV0: PV of the Cash Flow today
 Example
Reena has Rs1,000 to invest for 1 year
at an annual interest rate of 12%.

Annual FV = 1,000(1+ [.12/1])(1)(1)

= 1,120
Semi FV = 1,000(1+ [.12/2])(2)(1)
= 1,123.6
Effective vs. Nominal Rate of
Interest
Rs. 1000 Rs.1123.6
So,
Rs. 1000 grows @ 12.36% annually
Effective Rate of Interest
m
r = 1 + i/m -1
 Problem

Basket Wonders has a Rs1,000 deposit

at the bank. The interest rate is 6%
compounded quarterly for 1 year.
What is the Effective Annual Interest
Rate (EAR)?

EAR = ( 1 + 6% / 4 )4 - 1
= 1.0614 - 1 = .0614 or
6.14%!
 Perpetuity
 A perpetuity is an annuity with an
infinite number of cash flows.
 The present value of cash flows
occurring in the distant future is very
close to zero.
At 10% interest, the PV of Rs 100 cash
flow occurring 50 years from today is
Rs 0.85!
 Present Value of a
Perpetuity
A A A
PVAn    ... 
(1  i ) (1  i ) 2
(1  i ) n

When n=
PVperpetuity = [A/(1+i)]
[1-1/(1+i)]
= A(1/i) = A/i
 Present Value of a
Perpetuity
What is the present value of a
perpetuity of Rs270 per year if the
interest rate is 12% per year?

PV A Rs270 
perpetuity   Rs 2250
i 0.12
 Amortizing a Loan
Reena is borrowing Rs10,000 at a compound
annual interest rate of 12%. Amortize the loan
if annual payments are made for 5 years.

Step 1: Payment

PV0 = R (PVIFA i%,n)

Rs10,000 = R (PVIFA 12%,5)
Rs10,000 = R (3.605)
R = Rs10,000 / 3.605 = Rs2,774
 Amortizing a Loan
End of Payment Interest Principal Ending
Year Balance
0
1
2
3
4
5
 Amortizing a Loan
End of Payment Interest Principal Ending
Year Balance
0 --- --- --- Rs10,000
1 Rs2,774 Rs1,200 Rs1,574 8,426
2 2,774 1,011 1,763 6,663
3 2,774 800 1,974 4,689
4 2,774 563 2,211 2,478
5 2,775 297 2,478 0
Rs13,871 Rs3,871 Rs10,000

[Last Payment Slightly Higher Due to Rounding]

 Usefulness of Amortization

1. Determine Interest Expense --

Interest expenses may reduce
taxable income of the firm.
2. Calculate Debt Outstanding -- The
quantity of outstanding debt
may be used in financing the
day-to-day activities of the firm.